June 30, 2012 DK EQUITY GROWTH FUND

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1 June 30, 2012 DK EQUITY GROWTH FUND

2 DK EQUITY GROWTH FUND Quarterly Report June 30, 2012 Rates of Return 1 3 Mths YTD 1 Yr 2 Yrs 3 Yrs 4 Yrs 5 Yrs 10 Yrs. 15 Yrs Since Inception March 31, 1993 DK Equity Growth Fund -17.9% -15.4% -29.8% -3.6% 10.3% -3.1% -5.8% 14.1% 10.8% 15.4% S&P/TSX Composite Index -5.7% -1.5% -10.3% 4.2% 6.7% -2.5% -0.7% 7.6% 6.2% 8.6% S&P 500 (in U.S. Dollars) -2.8% 9.5% 5.4% 17.4% 16.4% 3.9% 0.2% 5.3% 4.8% 8.0% When looking at the rate of return numbers for the second quarter and the year to date, you might come to two conclusions. Firstly, that the world has come to an end. Secondly, that the businesses that we have invested in are in serious trouble. Neither is close to the truth. Yes, there are things to worry about. Serious matters in fact. The Euro Zone is in trouble. Too much debt in many of these countries, and too little tax revenue to support that debt. Growth in the BRIC countries (Brazil, Russia, India, China), the engine of global expansion for the past few years, is beginning to slow. The biggest negative impact of all these worries is on commodity prices and the market values of companies that produce these various commodities. This is a very similar situation to that which existed in the late 1990 s and which we at Deans Knight lived and invested through. The Asian Crisis was a period of financial crisis that gripped Asia beginning in mid-1997, and led to fears of a global economic collapse because of the potential financial contagion. Sound familiar (read Europe)? The crisis began with the collapse of the Thai Baht under Thailand s excessive burden of debt. Sound familiar (read Greece)? The crisis spread to Indonesia, South Korea, Hong Kong, Malaysia, Laos, Philippines, China, Taiwan, Singapore, Brunei, Vietnam and economic growth slowed sharply in all these countries. The IMF stepped in with a series of rescue packages. The effects of the crisis lingered through 1998, but by mid-1999, the economies of Asia began to recover. The Asian crisis, because of the resulting fear of global contagion, caused a significant decline in commodity prices and, similar to today s environment, a significant decline in the market values of commodity producing companies. Remember at that time, oil fell to $10 per barrel and a cover 1 Returns longer than one year are annualized gross of management fees.

3 story for the Economist Magazine appeared March 4, 1999 entitled Drowning in Oil which talked of $5 oil. Well, in the ensuing 9 years oil rose to $145 per barrel. 2 As we have maintained for some time, the problem with the future is that it is difficult to predict. Many learned books have been written about our inability to predict the future, but for some crazy reason we mere mortals have a craving, an insatiable appetite, for predictions. Just turn on any business television channel or pick up any business journal. You will find that most of the content is devoted to predictions. We are simply addicted to predictions, even though it has been proven conclusively that no one possesses the talent to predict with any accuracy. All one can say is the following, the future will be different from the present to some degree at some point, and I have anecdotes and hearsay to prove it. One thing that science has taught us is that we are human beings, fraught with weaknesses and biases. We tend to see the future, heavily biased by events in the present and recent past. Reference the Asian crisis... commodity prices go down... prediction... they will continue to go down... wrong! The depressing decade of the 1970 s that we have written about before... inflation... stagnant growth... oil price spikes... loss of confidence in U.S. leadership. This is similar to the situation we find ourselves in today. Back then the benchmark U.S. stock indices had shown zero return for a decade... today, these same benchmarks have shown zero growth for the past 13 years. The bearish sentiment today is at similar high levels now as it was in 1979 when that famous Business Week story appeared announcing the death of equities, on August 13, The magazine argued, for better or worse... the U.S. economy probably has to regard the death of equities as a near-permanent condition. Great timing! Over the next 20 years the market returned roughly 18% per year. Eerily similar stories are beginning to reappear today, rationalizing how and why stock prices will never rise again. The evidence regarding the weakness of human behavior is overwhelmingly convincing. Individuals have a bad habit of investing as if they were driving forward while watching in the rearview mirror. Individuals sell after periods of poor performance and buy after periods of strong performance. Most investors are noise traders... becoming overly optimistic in bull markets and overly pessimistic in bear markets.

4 3 A recent example of the pitfalls of predicting the future in the context of recent events was the change in outlook for the nuclear power industry following the March 2011 Japanese tsunami and Fukushima nuclear power plant debacle. The popular view that emerged at the time was that the debacle would derail the growth of nuclear power generation in the future. As a consequence, uranium prices fell and so did the shares of producers. In the immediate aftermath of the Fukushima incident, because Japan shut down its reactors, and Germany switched off some as well, nuclear power generation did decline. Now here we are 16 months later, and the amount of electricity generated from nuclear power has now risen to an all time high. Moreover, there are more nuclear reactors currently under construction now than before the Fukushima meltdown. So much for forecasting based on recent news. Let us look at a current example, one which has affected the market value of one of our investments, Coalspur Mines Ltd., in a very negative way. With the problems in Europe, sputtering growth in the U.S., slowdowns in the BRICs, the popular delusion is that the demand for thermal coal (the type of coal used to make electricity) will decline, and never recover. So far in 2012, thermal coal prices have declined by more than 20%, and are down 40% from the early 2011 high. As a consequence, Coalspur s market price has declined from a peak of roughly $2.25 per share in January of last year to a low of just under 70ȼ per share in late June. Overreaction? Thermal coal fuels 41% of all electricity production worldwide, dwarfing all other sources. Coal is followed by natural gas (21%), hydro (16%), nuclear (13%), oil (5%), and all others (4%). 2 The price of coal is cyclical and can move up and down based on short-term changes in the supply / demand balance. That said, as the world does more business and demands more power, the world demands more thermal coal. Growth in Seaborne thermal coal demand has averaged 10% annually between 1978 and The challenge that Coalspur faces at this juncture is raising the capital to build the mine and commence initial production by early At times such as this, with declining coal prices, and concern over global economic growth prospects, the market value gets excessively punished. Investors tend to forget all of the positive attributes that Coalspur has, and they ascribe no value to these. It is located in Hinton Alberta, one of the best mining jurisdictions in the world with 100 years of coal mining history in the area. The Bankable Feasibility Study shows marketable production capacity of 12 million tons per annum (mtpa), with additional upside potential, over a 28-year mine life. This same study highlights a low operating and capital cost base due to the low strip ratios and transportation cost advantages. The project is adjacent to CN Rail, which connects to the Ridley Terminals deep water port in Prince Rupert, BC. Coalspur has negotiated a Memorandum of Understanding (MOU) with CN to provide rail capacity of up to 11.2 mtpa beginning in This agreement is scheduled to be completed in the second half of Coalspur has secured port capacity at Ridley commencing 2015 for 10 mtpa, with an option for an additional 3.5 mtpa. 2 IEA World Energy Outlook 2011

5 4 Shipping distances to target markets in Southeast Asia are shorter from Prince Rupert than from Newcastle, in south east Australia. Cost advantage. With all of its coal being exported, the Vista project is marketing to a global market, which currently has more favourable terms than North America. Coalspur has a proven management team and a very strong Board of Directors. We are familiar with management and key Board members, as we have worked with and invested with them in the past. Current market value of the company is shy of $450 million. Depending on the average price of thermal coal over the 28-year mine life, Coalspur has the potential to generate cash flow per annum in excess of $600 million. At a market cap of $450 million, if Coalspur can meet and overcome the challenges that lie ahead, the owners of the business will do very well indeed over the life of the mine. It is important to note that Coalspur is just one example of many in the portfolio. Further, to demonstrate how the market has been mispricing our businesses you need look no further than Heroux-Devtek. Subsequent to the quarter, on July 17 th, the Company sold half its business for an amount equal to the entire market cap of the company the day before the transaction. The Company will receive after-tax cash proceeds of $230 million or $7.60 per share for its Aerostructure and Industrial parts businesses. The stock closed at $7.85 the day before this deal was announced. The Company s remaining landing gear business generates $250 million in Sales and $35-40 million in EBITDA annually. Using similar metrics to the transaction this would value the landing gear business at $11 per share giving a total implied value for the company of $ At time of writing the stock was trading at $ This transaction not only benefits our clients greatly, but also demonstrates what we have described as a massive disconnect between the true value of our invested companies and the value attributed by the market.